Financial Makeover: Diversify and Prosper

Dec. 8, 2003 -- — Q U E S T I O N: My retirement accounts are spread among seven plans. I am hoping to find employment again and defer accessing other retirement funds for six to eight years. By maximizing my recent years' contributions to retirement funds, I have been trying to maintain their values, which have been negatively impacted by the market's fall in recent years. I think I should invest in some stable individual stocks, but do not know which ones to select or when. I have concerns with some of my more risky mutual funds. I would like to get with a program I can monitor and manage without feeling overwhelmed. My goal is to be in control of my funds and reasonably maximize their growth without risking too much foolishly.

— Nancie

A N S W E R:

With money stashed in seven different retirement plans, Nancie and her husband, Rob, are feeling overwhelmed by the task of monitoring and managing their far-flung investments — and who could blame them? They're looking for opportunities to simplify and coordinate their investments, as well as for some guidance about when and how to select investments. And while Nancie and Rob were prompted to write by their nearing retirement, the principles discussed below can apply to any investor.

Diversification: Key to Long-Term Success

A big part of the reason that so many people procrastinate about investing is that it appears to be so complicated. The media fuels this perception by publishing magazines with provocative cover articles touting "The 12 Funds You Must Own Now!" or "Six Stocks to Own This Year!" or "10 Funds for 2004!" Articles like these create the perception that you should always be doing something with your investments — and soon! Fortunately, investing doesn't need to be complicated. In fact, it can be quite dull, and I would argue that that's the way it should be.

Investing is not about gambling or "playing the market" or finding the best performing stock or mutual fund for the year. Investing is about tapping into the long-term growth potential of companies and economies around the world as a way to reach one's personal financial goals. For most people, the best way to do this is to create an investment portfolio using broadly diversified mutual funds called index funds, which simply match the performance of the broad stock market as a whole.

Index funds are an ideal option for people who want broad diversification and long-term growth potential, but who don't have the time or skill to evaluate and monitor a portfolio of stocks or actively managed mutual funds that try to beat the indexes. Index funds are also generally less expensive to operate than actively managed funds, and these savings are passed on to investors. Moreover, history shows that the majority of actively managed funds actually underperform the indexes they're trying to beat, so there's a good chance that index fund investors will also enjoy superior long-term performance.

In summary, a diversified index-fund approach ensures that your investment portfolio will reflect the aggregate investment performance of the stock and bond markets as a whole, which over time have provided significant returns to disciplined investors. Moreover, it's a relatively low-maintenance portfolio that frees you from the chore of trying to stay on top of your portfolio of stocks or actively managed funds.

Putting Diversification to Work for You

How can Nancie and Rob put this idea to work to simplify their lives? As an example, they could reallocate their investments 40 percent to an S&P 500 index fund (U.S. large companies), 10 percent to a Russell 2000 index fund (U.S. small companies), 10 percent to an EAFE index fund (overseas companies) and 40 percent to a bond index fund. With just four funds, they will own a globally diversified portfolio of several thousand stocks and a healthy dose of bonds. This all-weather portfolio will generate solid long-term investment performance, but it will not top the charts in any one year. More importantly, they won't lose their shirt in bear markets, which is especially important to consider as they approach retirement.

Many company-sponsored retirement plans include index funds among the investment options. Many retirement plans also offer one or more "portfolio funds," which are mutual funds that own several underlying mutual funds. These "pre-mixed" portfolios of funds are often the best option for investors who want to allocate their accounts to a single, highly diversified fund.

Armed with a diversification strategy, Nancie and Rob can begin to put their plan into action.

Consolidate Accounts for Peace of Mind

Nancie and Rob have wisely taken advantage of the retirement plans offered by their employers throughout their careers, and they've accumulated seven retirement accounts to show for it. Having so many accounts makes it difficult to develop a coherent and unified investment plan. Fortunately, the law allows employees to roll over their retirement plans from former employers into an IRA account without incurring taxes.

Nancie and Rob should each open one IRA account at Vanguard (www.vanguard.com) and consolidate their seven accounts down to just two, which is much more manageable. (Vanguard offers a number of very low-cost index mutual funds, making them a good choice to implement a diversified strategy.) They can initiate this consolidation by calling each of the seven plans they currently have and requesting a "direct rollover" to the new Vanguard IRAs.

Once the Vanguard accounts are open, they'll then be in a position to implement the index fund approach I describe above. An even easier approach would be for them to purchase the Vanguard LifeStrategy Moderate Growth Fund, a "portfolio fund" that combines bonds with thousands of U.S. and international stocks for a very diversified, low-cost portfolio in a single fund.

Maintain Discipline at All Times

The hardest part of any rational investment plan is sticking with the plan through thick and thin, despite all of the messages to the contrary coming from the media, co-workers and relatives. In the late 1990s, many investors succumbed to greed and abandoned a diversified, sensible approach to investing and instead allocated their life savings to technology stocks (remember the "New Economy"?). Many of these people subsequently lost more than 50 percent of their savings.

Over the same time period, an investor with a broadly diversified mix of stock and bond index funds would have also suffered some short-term losses, but would have earned positive returns over the last five years. This investor would have needed the conviction to stick with a diversified approach even as many people called diversification foolish and outdated in the late 1990s.

By consolidating their accounts down to a manageable number and then creating and sticking with a rational, diversified and low maintenance investment plan, Nancie and Rob will spend far less time and energy worrying about their investments, which means they have more time to enjoy life.

Need to get your finances in order? Apply for a makeover

Guest columnist Greg Schick, CFP, is a financial planner at Kochis Fitz, a wealth-management firm in San Francisco.